Inflation

Few economic concepts touch daily life as directly as inflation. When prices climb faster than wages, household budgets feel the squeeze; when they climb out of control, economies can unravel. The years following 2021 reminded the UK and much of the world how disruptive inflation can be after a long period of calm. Understanding how inflation is measured, what causes it, who it hurts, and how the Bank of England tries to control it is essential to making sense of modern economic policy.

What inflation is and how it is measured

Inflation is a sustained rise in the general price level of goods and services, which reduces the purchasing power of money — each pound buys less than before. The emphasis on sustained and general matters: a one-off jump in the price of a single good is not inflation. It is the broad, ongoing upward trend that counts, usually expressed as an annual percentage.

In the UK, the main gauge is the Consumer Prices Index (CPI), compiled by the Office for National Statistics. The CPI tracks the average change in the prices of a representative basket of goods and services bought by a typical household — food, fuel, rent, transport, haircuts and much more. Each item is weighted by how much households spend on it, so a rise in energy bills counts for more than a rise in the price of, say, postage stamps. The basket is refreshed each year to reflect changing habits, and the annual percentage change in the CPI is the headline inflation rate.

It helps to distinguish related terms. Disinflation is a fall in the rate of inflation — prices still rise, but more slowly. Deflation is a fall in the price level itself, meaning negative inflation. Deflation sounds appealing but can be dangerous, as we will see.

Two engines: demand-pull and cost-push

Economists group the causes of inflation into two broad types.

Demand-pull inflation arises when aggregate demand grows faster than the economy’s ability to supply goods and services — the classic image of “too much money chasing too few goods.” It tends to appear when the economy is running near full capacity, so a surge in spending pulls prices up rather than expanding output.

Cost-push inflation comes from the supply side, when the costs of production rise and firms pass them on. Higher wages, dearer raw materials, or surging energy prices can all trigger it. A sharp rise in global oil or gas prices is the textbook example, and it can push prices up even when demand is weak. The post-2021 episode combined both forces: recovering demand met disrupted supply chains and a spike in energy costs.

Who wins and who loses

Inflation is rarely neutral. Because it erodes the value of money over time, it redistributes between groups, especially when it is unexpected:

• Borrowers with fixed-rate debt tend to gain, because they repay loans in money worth less than when they borrowed.
• Savers and lenders tend to lose for the same reason, as the real value of their money shrinks.
• People on fixed incomes, whose pay or pensions do not rise with prices, see their real living standards fall.

This is why economists focus on real wages — pay adjusted for inflation. If prices rise faster than wages, real wages fall even if the headline pay figure goes up.

Deflation brings its own dangers. If prices are expected to keep falling, consumers may delay spending, weakening demand and growth, while the real burden of debt rises because loans must be repaid in money worth more. This is a key reason central banks aim for low positive inflation rather than zero.

The UK’s 2% target

To anchor expectations and keep inflation in check, the UK operates an inflation-targeting framework. The Government sets the Bank of England a symmetric 2% CPI target, and the Bank’s Monetary Policy Committee uses interest rates to try to keep inflation close to it over the medium term.

Why 2% rather than zero?

A small positive target provides a buffer against deflation, gives wages and prices room to adjust, and allows for the fact that inflation is hard to measure perfectly. Aiming for exactly zero would risk tipping the economy into harmful deflation.

The framework also builds in accountability. If CPI inflation strays more than one percentage point above or below target — above 3% or below 1% — the Governor must write an open letter to the Chancellor explaining why and what the Bank is doing about it.

Why expectations matter

A subtle but crucial point is that inflation depends partly on what people expect. If households and firms expect higher inflation, workers demand higher wages and businesses set higher prices, which can make inflation self-fulfilling. Keeping expectations anchored near the 2% target is therefore central to monetary policy, and it is why the credibility of the central bank is so prized.

The stakes of losing control are stark. Hyperinflation — prices rising more than 50% a month — typically follows governments printing money to fund spending, and it can destroy a currency and wipe out savings, as in 1920s Germany or 2000s Zimbabwe. Such extremes are a powerful reminder of why stable, predictable, low inflation is one of the central goals of economic policy.